FDI in the Defence Industry

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Category: Strategic Research Review
Published: Thursday, 29 June 2006 17:43
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Maj. Gen. (Retd) Mrinal Suman, AVSM, VSM

The Government of India has been taking a number of steps to achieve the target of  procuring 70 per cent of its defence requirements from indigenous sources by 2010. Despite its best efforts over the last two decades, India is nowhere near that objective as yet. We continue to depend on imports for all our major requirements while the indigenous production is limited to low-tech low-end items and a few products based on bought technology. It will not be incorrect to surmise that India has failed to be self reliant in defence production despite decades of efforts and thousands of crores of rupees expenditure. Over-dependence on the public sector has been one of the major reasons for this failure.

With liberalisation of economy, there has been a welcome change in the thinking of the national leadership. It realised that the objective of 70 per cent indigenous production would continue to remain a pipe dream for the country unless the private sector was co-opted. The private sector, in the meanwhile, had already proved its credentials by emerging as a vibrant and dynamic force, especially in the field of information technology. Its potential could no longer be ignored. In a land mark policy change, the defence industry was thrown open to the private sector in May 2001 (Press Note 4 of 2001 Series). The Government permitted 100 per cent equity with a maximum of 26 per cent Foreign Direct Investment (FDI) component, both subject to licencing. Subsequently, the Department of Industrial Policy and Promotion issued detailed guidelines, after consultations with the Ministry of Defence, for the issuance of licence for the production of arms and ammunition in January 2002 (Note 2 of 2002 Series).

However, things with regard to FDI have not progressed the way the Government had hoped. Despite the fact that India is expected to spend approximately 1,80,000 crore rupees on defence purchases in the next 5 years, there has been a total lack of enthusiasm on the part of foreign investors to invest in the Indian defence sector . Mr George Fernandes was quite candid in admitting in the Lok Sabha in 2004 that not a single proposal of FDI for manufacturing defence related products had been received till then. He attributed this lack of interest to ‘the individual entrepreneur’s decision depending on his commercial perception’. It is as frank an admission of failure of the policy as could be expected.

The World Bank defines FDI as ‘net inflows of investment to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor’. FDI comprises of funds provided by the foreign direct investor to the FDI enterprise as equity capital, reinvested earnings and intra-company loans.

FDI is not just a question of getting funds, but access to the latest technologies. FDI pre-supposes a long term commitment and lasting relationship between the foreign and local enterprise. FDI sets in motion a chain reaction wherein FDI upgrades local technology which, in turn, attracts more FDI with higher technology and the cycle goes on. This is of vital importance to the defence sector which is highly capital intensive and undergoes rapid obsolescence of technology.

While participating in a seminar organized by the Confederation of Indian Industry during the Defence Exhibition in 2004, the then Minister of State for Defence Mr Chaman Lal Gupta acknowledged that the basic aim of allowing FDI in defence sector was to pool capital and induct latest technology to manufacture state-of-art defence equipment for own armed forces and also to enter the export market at a significant scale.

Peculiarities of FDI in Defence

FDI in defence industry is indeed essential because most defence products involve a relatively high level of technology and this technology gets transferred only if the foreign partner has a long term stake in the company. The aim of seeking FDI by India in its defence sector may be to get both funds and technology. But given the present comfortable economic environment, it is primarily defence technology that India needs desperately. Hence, a different approach is required.

Some of the major factors that influence FDI in defence industry are -

·         Rapid obsolescence of defence technology makes it imperative that the selection of technology be carried out diligently. All official sanctions and licences must be issued without bureaucratic delays. Most importantly, production must commence in the given time frame lest technological advances make the whole project anachronistic and a waste of resources.

·         Modern defence systems are highly complex and are not available from a single source. In addition to procuring/producing various systems, sub-systems and components, a systems integrator has to be identified for optimum performance. This may entail negotiations with more than one foreign investor from more than one country. Most of the major defence equipment producers follow ‘Global Factory’ concept, wherein various functions are spread over a number of locations in different countries with a view to draw maximum benefits in terms of technological expertise, cheap labour and abundant raw material that different locations offer. Therefore, any nation that covets FDI in defence has to tailor its policies to suit this world-wide network.

·         Due to heavy initial investment, the number of defence equipment manufacturers is limited in the world. Very few possess the latest technology that is sought. Additionally, embargoes on technology export by some countries make the choice highly narrow.

·         Market for defence equipment is extremely competitive and restricted. Most of the countries give preference to their indigenous manufacturers. International arms trade does not follow the dynamics of an open and free market. Invariably, major defence procurements are an extension of a country’s foreign policy. Therefore, every prospective FDI investor wants a fair degree of assurance that the equipment produced will find buyers, more so as most of the defence equipment does not have dual-use and finds no application in non-defence sector.  

Present Policy and its Dissuasive Incongruities

As per the policy directive of 2002, licences for the production of arms and ammunition will be issued by the Department of Industrial Policy and Promotion (Ministry of Commerce and Industry) in consultation with Ministry of Defence, whereas all FDI cases will be considered by Foreign Investment Promotion Board as well. But it is the Ministry of Defence which will have the final say as regards procurements, sales and exports (even for non-lethal items).

Indian bureaucratic straitjacket is such that it can dissuade even the die-hard optimists. The applicant company has to be either an Indian company or a partnership firm. Management control must remain in Indian hands with majority representation in the board. The Chief Executive has to be a resident Indian. In other words, a foreign investor is expected to invest his resources without participating in decision making. The licencing authority can also verify the antecedents of the foreign collaborators and domestic promoters including their financial standing and credentials in the world market.

Though FDI limit is capped at 26 per cent, there would be no minimum capitalisation for the FDI.  The Government would assess the adequacy of the net worth of a foreign investor with respect to the category of weapons and equipment to be manufactured. A foreign investor cannot transfer his equity before the expiry of the lock-in period of three-years. Even after that, such transfers would be with the approval of the Government.

The licence will contain capacity norms for production, which will be fixed after considering existing capacities of similar and allied products. This provision appears to be meant to protect the interests of the public sector by ruling out any competition to their existing monopoly. A licensee can produce only the licensed products and in the sanctioned quantity. He can neither diversify nor enhance production to cater for the market dynamics. The Government will verify all safety and security procedures once the production commences.

As regards the sale of the products, the Government can give no purchase guarantee but the proposed quantity for acquisition and overall requirements may be made known to the extent possible. Purchase preference and price preference may be given to public sector producers as per the policy.

According to the directive issued by the Government of India (Department of Public Enterprises) on 26 October, 2004 , all Central Public Sector Enterprises will be given purchase preference if the price quoted by any of them is within 10 per cent of the lowest bid. This provision is applicable to all tenders where the value is Rs 5 crores or more. Additionally, Defence Procurement Manual 2005 stipulates that small scale industries can be given price preference of up to 15 per cent in comparison to large industries. These are highly inequitable stipulations, which militate against the basic canons of free market norms of fair play.

The policy directive further stipulates that arms and ammunition will be primarily sold to the Ministry of Defence. Their sale to other security organisations in the country and exports will be with the prior approval of the Government. Non-lethal items may be sold to non-Government agencies but with the concurrence of the Ministry of Defence.

The applicant company has to provide the standards and testing procedures for equipment to be produced to the nominated quality assurance agency. Further, the Government retains powers to inspect the finished product and conduct audit of quality assurance procedures.

Original investment as also the returns on investment are fully repatriable. Payment of fee and royalty to foreign technology provider is permitted including that by a wholly owned subsidiary to its off-shore parent company.

Thus, India expects a foreign investor to invest his resources in a venture where he has no significant control, strict capacity/product constraints, no purchase guarantee, no open access to other markets (including exports) and an unfair advantage to the local public sector. Such an expectation defies logic. No wonder that not a single application for FDI has been received by the Government so far. Many feel that such a lop-sided policy was destined to be a non-starter. 

The Way Ahead

It is prudent to understand as to what motivates an investor to invest his resources in another country and undertake risks associated with it. As investment in defence production means a lasting and protracted relationship, he seeks a stable environment with long term well defined economic policies which are fair and consistent.

Primarily, there are four factors which influence such decisions – availability of abundant raw material, skilled work force, low cost of production and lucrative market. It is the interplay of all these factors which influence an investment decision. As per a study carried out under the aegis of United Nations Industrial Development Organisation, influx of FDI in any sector is dependent on a number of determinants like stable policy, favourable investment climate, structural adjustments, economic freedom and a fair market access.

Attractiveness of a nation for foreign investments in any sector is judged by its ‘FDI Confidence Index’. For FDI in defence, India scores very poorly due to the inequitable Government policy which is highly loaded in favour of the local public sector enterprises.

During informal discussions, many foreign entrepreneurs have complained that Indian policy seems to have been drafted more to perpetuate the monopoly of the public sector rather than invite FDI. A number of them have also expressed apprehensions that after they invest their resources, any public sector enterprise could import similar technology from another source and invoke the provision of price/purchase preference for securing Government orders.

According to them, almost all provisions of the policy convey the impression that India is really not too keen for FDI in defence. Even the language of the directive reflects an apathetic and lackadaisical attitude. They recall the statement of Defence Minister Mr Pranab Mukherjee at Aero India 2005 where he had said, “The defence sector has been opened up for private investment and it is not that we are dying for investment. It is for the interested companies to make necessary investment.” They aver that the tone and the tenor of the statement could dampen the enthusiasm of prospective investors.

To make India a favoured destination for FDI in defence production, there is an urgent need for a total policy review. The Government has to first decide as to what its long term goals are and define the objectives by phases with time frames.

FDI in defence could either be in a Greenfield project or through merger/acquisition. Normally, developing countries attract Greenfield projects, whereas acquisitions/mergers are more prevalent in developed nations. India today stands at a threshold where both the options can be exercised.

Ideally, Exports should be encouraged to ensure economic viability of an enterprise as also to earn foreign exchange to offset the initial foreign exchange outflow and repatriation by foreign investors. 

Image building is absolutely essential. Efforts to attract FDI through investment promotion have become indispensable. Investment promotion is generally defined as ‘activities that disseminate information about, or attempt to create an image of the investment site and provide investment services for the prospective investors’. Investment promotion in defence sector needs expert handling as investors are few and highly selective.

Almost all countries provide various forms of investment incentives as well. These include fiscal incentives like tax breaks/holidays and financial incentives like grants/loans. They are also offered market preferences. It is equally essential to give maximum publicity to the incentives being offered. India should leverage its technical manpower against foreign technology.

Recommended Policy Framework

As discussed earlier, India ’s primary aim of inviting FDI in defence is to import much needed technology which would not be available otherwise. If that be the case, it stands to reason that the policy be tailored towards achieving that aim. Therefore, India should have a graduated policy which is technology specific.

The policy must be a flexible one to attract frontier technology. Application of various clauses should be based on the type and level of technology being infused. For example, FDI in the production of radars, telecommunications, surveillance equipment, sensors, night vision devices, aero-engines, avionics, medium guns and such high-tech equipment should be facilitated by giving irresistible incentives. In case of cutting edge technology, FDI limit could be increased to 51 percent to instill confidence in the foreign entrepreneur that he would continue to own the enterprise by holding majority stake.

The Government must provide adequate freedom to a foreign investor to cater to market dynamics, albeit within the broad regulatory policy framework. He should not feel stifled or handicapped due to excessive monitoring by the bureaucracy. Restrictions on capacity should be relaxed so as to enable economies of scale. It will also reduce India ’s procurement price. Import of dual use technology should also be encouraged as it benefits other segments of the economy as well.

Excess production should be permitted to be exported or sold elsewhere depending upon the lethality of equipment and the need to safeguard the technology. This aspect could be indicated in the licence itself to reassure the investor.

It is understandable that the Government can give no purchase guarantee at the time of issuance of licence. But it can certainly provide a level playing field to all. There should be no price/purchase preference for public sector units. They must be forced to participate in an open competition.  It will compel them to upgrade and improve their functioning to survive.

Although offsets amounting to 30 per cent for contracts exceeding 300 crore rupees have been made mandatory in Defence Procurement Procedure-2005, detailed guidelines are yet to be issued. Infusion of FDI through technology transfer in joint-productions should be encouraged under offset obligations.

The Government should offer price and/or purchase preference to items produced in the country. This single step will make all foreign vendors examine feasibility of local production more seriously. Of course, local production has to be categorised in terms of value addition and technology transfer lest mere assembly/integration of imported sub-assemblies gets passed as local production.